Saturday, August 19, 2017

Bank Equity Investors vs Bond Investors

This is from an On Beyond Investing blog post (he's a Canadian guy watching the Toronto bubble):

Short sellers (I include myself in this group) are from the trading and hedge fund world. In this world, market prices change as probabilities change. An example would be corporate bond trading. If a hedge fund buys a corporate bond and the probability of default decreases, the bond will go up in price and the hedge fund makes money. If the probability of default increases, the bond price drops and the fund loses money. Betting on changing probabilities is largely how traders and hedge funds make their money.

The accounting for Canadian financials does not operate in the world of probabilities. Lenders only reflect losses when defaults occur. There is very little provision for losses due to changes in the probability of defaults. While this difference of worldview - probability versus actual default - seems small, it is actually a huge deal.

An investor that does not view investing through a probability lens looks at the reported earnings from Canadian lenders and thinks ‘what’s the big deal?’. Earnings are at record highs, return on equity is great, defaults are low, and there is low provisions for losses. Great report.

An investor trained to view the world through the lens of probabilities looks at the same report and thinks: ‘Houses are so expensive that future losses seem inevitable - why aren’t they reserving more now?’ or ‘There is so much personal debt that the probability and number of defaults is likely to rise, why isn’t that reflected?’ or ‘If we look through a cycle of defaults and normalize earnings for higher losses the income statement would be much lower and ROE’s much less; why isn’t this riskiness being demonstrated in the accounting?’

The same financial statements - very different perspectives. In fact, these views are so different that the two groups can hardly find common ground to discuss.
This was true in 2006-2008 as well. I remember someone saying that Downey wouldn't fail because it had good levels of capital. Sure... until the onslaught of defaults on their bad loans made it impossible to pretend that anymore.

After the past 8 years, I look at investing and central banking less naively, through a political lens. One job of a central bank is to periodically pull the rug out from under would-be elites by tightening money when their me-too investments are coming online, so that the real elite can buy them at auction.

The Canadian housing market is tough to figure without knowing the politics there. Are they going to let the upper class lose their shirts, and have all their banks go under, by allowing housing prices to fall back to "sensible levels"? Or will they bail out / devalue / quantitatively ease? Or will there be a bear market that purges some of the nonsense while setting up the elite to make massive profits?

Would it be better to just bet against the CAD?

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